Golden leashes – compensation arrangements between activists and their nominees to target boards – have emerged as the latest advance (or atrocity, depending on your point of view) in the long running battle between activists and defenders of the long-term investor faith. Just exactly what are we worried about?
With average holding periods for U.S. equity investors having shriveled from five years in the 1980s to nine months or less today, the defenders of “long-termism” would seem to have lost the war, though perhaps not the argument. After all, if the average shareholder is only sticking around for nine months, and if directors owe their duties to their shareholders (average or otherwise), then at best a director on average will have nine months to maximize the value of those shares. Starting now. Or maybe starting nine months ago.
But this assumes that the directors of any particular company have a real idea of just how long their particular set of “average” shareholders will stick around, and it also assumes that the directors owe duties primarily to their average shareholders, and not to their Warren Buffett investors (on one hand) or their high speed traders (on the other). So, in the absence of any real information about how long any then-current set of shareholders will invest for on average, and in the absence of any rational analytical framework to decide which subset(s) of shareholders they should be acting for, what is a director to do?
Here is what I think directors do, in one form or fashion or another:
They say to themselves, “I have a good sense of what the company’s opportunities are, in terms of long-term growth, and in terms of shorter-term options, like a share buyback, a spin-off, or a sale. Since I don’t know how long any of my shareholders will be sticking around for, what seems fair, is to probability weight the various outcomes of share price increases from a long-term growth strategy versus the various shorter-term strategic alternatives, and decide based on the net present value of those probability-weighted outcomes, what yields the highest current net present value.” While no directors probably think exactly this way (unless they are confronted with a clear choice between, e.g., doing a stock buyback versus embarking on an expensive capex program), I do think this reflects (albeit in a cartoonishly precise way) what directors are doing when they choose a strategic direction.
Assuming perfect knowledge and universal agreement on the correct probability weighting, risk tolerance and present value methodology, this approach should yield the highest share price at all times – regardless of any investor’s timeframe – thus resolving once and forever the false debate between short-termism and long-termism.
Sort of. In fact, the problem still exists in the real world, due to the unfortunate lack of perfect knowledge,  and equally unfortunate disagreements regarding probability weighting, risk tolerances and, to a lesser degree, present value discount rates and methodologies. The short-termers (henceforth, in order to continue the theme of cartoonish oversimplification, “activist hedge funds”) and the long-termers (in a similar vein, henceforth known as “management”), in particular seem to clash over probability weighting and, less openly though perhaps as fundamentally, risk tolerances. 
According to this narrative, activist hedge funds are constantly pushing for short-term actions – share buybacks, spin-offs, sales – either because they more heavily discount the probability of success of long-term actions (or simply think the broader market will too heavily discount the probability of success of a long-term strategy), or because they have a lower risk tolerance than management. Management, per this same narrative, is always too certain of the success of its long-term plans, or alternatively – in the most vitriolic forms of this narrative – they are entrenched self-dealing types who just don’t care about their shareholders.
It may be worth pausing for just a moment on the two aspects of this analysis – probability weighting and risk tolerances – that are the implicit subject of many a long-term v. short-term battle.
In one sense, probability weighting of the success of various alternative strategies – though it is at the heart of the director’s job – presents the simpler issue for our immediate purpose of determining which forms of incentives offered by activists to their board nominees may be improper. Either the Board is correct in probability weighting the success of various strategies, or it is wrong to one degree or another. Individual shareholder preferences do not come into play – regardless of who the shareholders are; there is a right answer and a wrong answer. As in any “right or wrong” issue, the shareholders who are right in doing the probability weighting will be able to make money from investors who are wrong, and those who are wrong will lose money. And of course, if the Board is wrong, then shareholders in the aggregate will lose money, regardless of their individual long- or short-term orientation. Accordingly, it is hard to imagine that an activist investor would wish to incentivize one of its board nominees to make the wrong analysis of the probability-weighted success of various alternative strategies open to the corporation – nobody makes money from directors shutting their eyes.
Risk tolerances are a bit different, as they reflect individual investor preferences, and they may be affected by the investor’s time horizon. An example might be helpful.
Consider a case where directors are faced with a choice between Strategy A – implementing a leveraged stock buyback plan, which has a 100 percent chance of adding $1 to the share price in the short term – and Strategy B – a long-term capex plan, that has a 60 percent chance of adding $2 per share (on a net present value basis) to the market price two years from adoption. The immediate risk-adjusted value of the long-term capex alternative would be $1.20, but whether this is actually more attractive to the Board than the $1 per share “sure thing” will depend on its collective risk tolerance. Interestingly, the Board might have a lower risk tolerance than its shareholders for a simple reason: the Board (and the company) has only one shot at achieving the desired result, with a 40 percent chance of not succeeding. If the Board had two shots at getting it right, they would have only a 16 percent of getting nothing, a 48 percent chance of getting (on average) $1, and a 36 percent chance of getting (on average) $2. The more times the Board has to roll the dice, the more likely they are to realize (on average) the risk adjusted value of $1.20. In other words, the more times the Board can roll the dice, the more they reduce the 40 percent chance that they end up with zero.
What is interesting about this is that shareholders with a diversified portfolio may have more than one company in their portfolio facing similar odds – in effect, the shareholders get to roll the dice multiple times. Accordingly, one would think that shareholders, rather than pressing for the short-term payoff, would more typically be pressing for the riskier long-term payoff, which is clearly at odds with the cartoon scenario depicted above.  Again, there are two traditional explanations that can be employed to solve this conundrum.
Fans of activist shareholders will argue that management’s risk tolerance is inappropriately high – that they are incentivized to seek to increase the option value of their control by extending the length of their control – effectively increasing their risk tolerance for long-term strategies (and possibly impairing their judgment of the probability-weighted success of long-term plans). In other words, management is improperly incentivized to think long-term “especially if because of poor performance and strategy [the option value of its control] is then out of the money.” 
On the other side of the equation, there may be another dynamic at work that lowers the risk tolerances of short-term investors. If shareholders are going to trade out, on average, within nine months – in fact in 4.5 months on average after any given announcement – they have to judge not only whether management has made the correct probability weighting, but also whether the market will give management full credit for its choice before they trade out. Even the most dedicated efficient market theorists will concede that it takes some time for all information about a particular strategic course to be filtered into and absorbed by the market. It seems reasonable to assume that the longer-term and riskier the strategy, the more time the market may need to absorb and judge.  If a board chooses Strategy B above (the option giving a 60 percent chance of a $2 return and 40 percent chance of zero return), and the market only gives $0.90 of credit for the choice in those first few months after the announcement, then the short-term shareholders will prefer the less risky Strategy A, yielding a 100 percent chance of a $1 return. So the risk tolerance of shareholders – particularly short-term shareholders – may be reduced by the inefficiencies of the market.
One could question why institutional holders would not simply hold their shares until the full $1.20 price increase was realized – everyone loves an undervalued stock, right? But regardless of whether you believe that investors have predetermined investment timeframes, there is another layer to the analysis that might cause diversified institutional shareholders, constantly on the lookout for the best value proposition, to prefer the less risky strategy.
To continue with the example above, assume on the day the Board makes its decision, the stock was at $5 per share. On the day after the Board selects Strategy B, the price per share increases not to $6.20 but only to $5.90. In simplest terms, the shareholder is now holding a stock with a 60 percent upside opportunity of $1.10 (risk adjusted upside of $0.66) and a 40 percent downside risk of $0.90 (risk adjusted downside of $0.36). (This compares with our theoretical pre-decision profile of a risk adjusted upside opportunity of $1 or $1.20 (depending on the strategy chosen) and zero downside risk.) In other words, the risk profile changes significantly, and, when compared to other opportunities in the market, may well push the institutional holder toward an immediate sale. Knowing this, and knowing that the market may take some time to give full value to the longer-term strategy, can only make diversified institutional shareholders – regardless of any fixed time horizon  – strong advocates for the lower risk alternative, which will allow them to capture the $1 gain immediately and then move on to greener pastures.
(And note that market inefficiencies may build on themselves. A sale by investors at $5.90 may look like the market is reacting negatively to the board’s choice of the long-term strategy – the market likely taking it as a vote of non-confidence in the strategic choice, rather than a rebalancing of a portfolio after a partial realization of a potential gain – which will put downward pressure on the company’s shares, making it even less likely that the company will get full credit in the short term for its choice of a long-term strategy.)
So, to sum up, no one will want to incentivize a director to make a poor analysis of probability-weighted outcomes, but there are differences in risk tolerances among investors – which may be driven in part by market inefficiencies (or simply by fears of market inefficiencies). An investor may wish to incentivize a director to adopt that investor’s risk tolerance, which may or may not be similar to the market in general or to the “average” shareholder or to any theoretical “optimal” risk tolerance.
The question of whether there is an “optimal” risk tolerance in any situation – high or low – is left to greater minds. But it may be worth noting that risk tolerances may be the least easily quantifiable of all the factors discussed above and the most prone to situational influences. Accordingly, even those most partial to hard and fast rules may view prescribing a particular optimal risk tolerance for all situations as impossible and admit to the necessity of deferring to the business judgment of the board – the honest broker between management and activist.
Which brings us, finally, to golden leashes.
Lately, in the context of a difficult proxy battle, Agrium Inc. complained mightily about the “golden leashes” placed by JANA Partners on JANA’s nominees for five (out of 12) Agrium board seats. These leashes consisted of payments to the JANA-nominated directors of a percentage of JANA’s profits from its investment in Agrium. JANA questioned how incentivizing board members to maximize share price could create a conflict of interest for directors. 
So what was Agrium worried about?
First, they may have been worried that otherwise nominally independent directors cannot possibly be truly independent if they are getting paid by one particular shareholder with a particular point of view – regardless of the form of payment. That seems to be a fairly fundamental objection, and shareholders prior to voting will presumably need to satisfy themselves that the proposed directors are in fact qualified, independent businessmen of sound judgment, and not lackeys of the insurgent. This question will get asked regardless of whether the insurgent provides any separate compensation to its nominees. JANA in response would argue that in order to get high quality, independent nominees to step into a contentious situation, something more than the usual director’s fee is appropriate and, in fact necessary. Again, absent misaligned risk tolerances, all investors should have the same interest in hiring directors best able to evaluate and correctly probability weight the various alternatives open to the company. So, if you assume all investors have the exact same risk tolerance (and further assume the intellectual honesty of the nominees), paying certain directors more to do this job should not be an issue.
Sadly for those who love simplicity, assuming that all shareholders have the same risk tolerance is certain to be contra-factual. This may explain why Agrium seemed to be more agitated by the form of the payment than the mere fact of the payment. Here, the argument gets more interesting. It is one thing if the nominees simply get a flat fee for services rendered, regardless of how they are rendered; it is quite another if the nominees get a share of JANA’s profits. Sharing JANA’s profits raises the question rather directly as to whether the amount of the payment to be received by the nominees depends on the timeframe in which the shares will be sold by JANA, and, if the timeframe will determine the ultimate price realized, whether it is appropriate for an honest broker to have a cash incentive to adhere to a particular timeframe, which is outside of the nominees’ control.  In other words, does the lack of control of the time of disposition mean that the nominees will be incentivized to adopt the risk tolerance of the insurgent?
To be fair, it did not appear that JANA had announced any specific timeframe for its exit, so at the time of nomination there would not seem to have been any attempt to influence the nominees on that basis.  On the other hand, JANA certainly had not handed over the disposition decision to its independent nominees – nor is it likely JANA could do so, having fiduciary duties to its own investors. Accordingly, there remained the specter of JANA tugging on that golden leash by announcing, for instance, that it would sell all its holdings within x months, or, more likely, that it thought strategy x would certainly lose money for the company, leaving the nominees to divine what sort of action would follow if strategy x were pursued. In short, the arrangement did seem to vest JANA with a means, however attenuated, of influencing the pocketbook of the nominees, and not just influencing their informed opinion. 
Courts will always scrutinize these arrangements to see if they will tend to make honest brokers any less honest. Any arrangement that potentially unhitches a director’s financial incentives from the exercise of his or her best judgment is bound to be viewed skeptically. And even if rational economic theory would tell us that all shareholders with the same risk tolerance should have the same interest at heart, courts will always scrutinize closely the independence of nominees with any sort of economic incentive to act on behalf of their proponents – even if there is no standard available for judging whether one sort of risk tolerance is better than another. 
 See Sanford J. Grossman and Joseph E. Stiglitz, On the Impossibility of Informationally Efficient Markets, 70 AM. ECON. REV. 393 (1980).
 Getting enough information into the market about a particular long-term strategy seems to be less of an issue between the two camps – perhaps because it is fairly clearly management’s responsibility – but, as discussed below, curing market inefficiencies by getting information to the market may be one of the most important ways to bridge the long-term/short-term gap. There may be cases where confidentiality concerns prevent the proper explanation of a longer-term strategy, but in that case no one should be surprised if the market undervalues that long-term strategy.
 Note however that, anecdotally at least, activist hedge funds are often thought to have significantly less diversified portfolios than other institutional investors, given their focus on effecting change at select targets, as opposed to locking in relative returns across a broad portfolio. Accordingly, based on this metric alone – which is of course but one of many – the risk tolerance of activist hedge funds might rationally be closer to that of the target board than that of its fellow institutional investors.
 Ronald J. Gilson and Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 COLUM. L. REV. (forthcoming May 2013).
 A board’s announcement that it is waiting for the business cycle to turn is certainly less likely to move the market than a merger proposal. However, as was evidenced in the great Airgas/Air Products battle, a board’s decision to wait for the business cycle to turn may well be a better strategic choice than selling into a premium offer. In that situation, the board (including independent directors nominated by the bidder Airgas) rejected Airgas’s premium offer of $70 per share, in the face of very strong shareholder sentiment in favor of a deal. Ten months after the bid was abandoned, the stock was trading at $75 per share. See Air Products and Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48 (2011).
 It seems more likely that diversified institutional holders focus less on holding shares for any particular length of time and more on optimizing their potential returns at all times.
 JANA went on to lose the proxy fight, and the story lost any further instructive value at that point. Other recent examples include Elliott Management placing “golden leashes” on its short slate of nominees to the board of Hess Corporation, consisting of a payment for each percentage point by which Hess outperformed its peers at the end of a three-year period. Elliott’s nominees waived their rights to these payments, saying they had become a distraction. In Carl Icahn’s proxy battle with Forest Laboratories, Inc., he offered his nominee one percent of his profits over a certain share price (which was about 30 percent over the market price at the time of the proxy fight).
 One could also consider whether getting a share of JANA’s profits would incentivize the nominees to adopt JANA’s view of the correct probability-weighted value of the different alternatives. Again, there would not seem to be much reason for the nominees (or JANA) to shut their eyes to a better value proposition, so long as they judged that value proposition with the same risk tolerance (informed by the same perception of market inefficiencies).
 The nominees would be entitled to a deemed profit on any shares still held by JANA after a three-year period, so effectively the scheme provided a strong incentive to maximize the share price on that date, to the extent JANA had not previously sold its shares. It should be noted that there are those who do not think three years is a “long-term” commitment to a corporation. For others, it seems almost impossible that it would take three years for the markets to efficiently value the prospects of a publicly traded company.
 The Deal Professor in his April 2, 2013 DealBook posting raised a great point about both the JANA and Elliott versions of golden leashes – both are upside-only payments. This creates an incentive that, taken to its extreme, might encourage a director to prefer a strategy with a 20 percent chance of making $10 and an 80 percent chance of losing $100 to a strategy with a 100 percent chance of making $2. Of course, as he also points out, this is also true to some extent of out-of-the-money options regularly awarded to management. Query whether upside-only incentives properly align the nominees’ interests with activist funds that presumably have millions invested in the target stock and millions of potential downside. See Steven M. Davidoff, Upping the Ante in a Play for a Stronger Board, N.Y. TIMES (Apr. 2, 2013), http://dealbook.nytimes.com/2013/04/02/upping-the-ante-in-a-play-for-a-stronger-board/.
 Some might argue, reasonably, that a risk tolerance skewed in favor of short-term actions is preferable, as it reflects the reality that most shareholders are in fact short-term shareholders. Whether that is good policy is another question entirely. As is the question as to whether one could adopt measures to eliminate or reduce market imperfections that lead to delays in the market reflecting a proper risk-weighted valuation for target’s shares (and that, as a result, skew risk tolerances).